How does the business cycle work?

It’s always a good thing to know that our economy – and investment – works in a cycle. If we were to look back over the past hundred years or so, we would see that our standard of living has increased dramatically. I mean, who would have thought 100 years ago that we’d have things like cellphones and computers? And who nowadays doesn’t own a cell phone?

While it’s easy to see the growth in our economy over a 100 years or so, it doesn’t mean that the economy grew steadily and smoothly over those hundred years.
Here’s what actually happens…

The four stages of a business cycle

Depending on whom you speak to, the four stages of a business cycle are as follows:

1. The recovery phase or upswing

This is a phase where the economy ‘troughs’ out. As the economy recovers from a recession, businesses start building up their stock levels in anticipation of increased sales. Factories now start employing more workers in order to produce the additional stock they require. As a result, unemployment drops.

2. The boom phase

The economy is now humming along quite fine. Companies are now exporting their product overseas, which means that money is flowing into South Africa. As the domestic money supply increases, so interest rates decline. When interest rates decline consumers start spending more. Increased demand for goods means that more and more goods are imported. Imports mean that money is now beginning to flow out of the country. As consumers spend more and more money, the demand for credit outstrips the availability of credit. This causes interest rates to rise.
A further problem is skilled labour, which is becoming scarce. This means higher salaries now have to be paid.

3. The downswing phase

As our products become more expensive (because of the increased labour cost) the demand for South African goods overseas starts to decline. Local businesses now start focussing on the domestic consumer instead. Because more money is flowing out as a result of imports, then money flowing in because of exports, the value of our Rand starts to decline. This results in imports becoming more expensive. In order to attract enough capital to meet the shortfall in the balance of payments, the government start increasing interest rates. Consumers now find it difficult to maintain their standard of living, and their demand for goods and services declines. Businesses now begin to lay off staff.

4. The recession phase

This period is also known as a trough. In this phase there is very little economic activity, which means that prices and profits start falling. As the demand for imports stops, the country’s current account improves. In this phase there is less buying, selling, production, and employment. If the recession gets severe then it becomes known as a depression.What is the textbook definition of a recession?
Recession is when we have two successive quarters of negative growth in our real gross domestic product.

But does a business cycle have to move through all four phases?

No cycle is ever the same.

How do we know in which portion of the business cycle will currently in?

Economists and pay a number of variables such as new-car sales, imports, unemployment, and retail sales to our real GDP (gross domestic product).
Some of these variables move in line with the business cycle (co-incident indicators), while others reach their peaks and troughs a few months before the business cycle (leading indicators).
By watching the leading indicators, we can pick up an early indication of things to come.

Why is the business cycle important to investors? You’ll have to read next week’s article in order to get the answer to that question!